credit creation by banks

8/3/2019 Credit Creation by Banks

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CREDITCREDIT CREATIONCREATION

BYBY BANKSBANKS

y Central Bank is the first source of moneysupply in the form of currency in circulation.

y

The RESERVE BANK OF INDIA is the noteissuing authority of the country. The RBI ensuresavailability of currency to meet the transactionneeds of the economy.

y The total volume of money in the economyshould be adequate to facilitate the various typesof economic activities such as production,

distribution & consumption.


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y The commercial banks are the

second most important sources of

money supply.

THE MONEY THAT COMMERCIALBANKS SUPPLY IS CALLED

CREDIT MONEY.

yThe process of CREDIT CREATIONbegins with banks lending money out of

primary deposits.


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Primary deposits are those deposits

which are deposited in banks.

In fact, banks cannot lend the entire

primary deposits as they are required to

maintain a certain proportion of primary

deposits in the form of reserves with theRBI under RBI & BANKING

REGULATION ACT.


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yAfter maintaining the required reserves,

the bank can lend the remaining portionof primary deposits. Here banks lend the

money and the process of credit creation

starts.

EXAMPLE :-

Suppose there are a number of commercialbanks in the banking system- bank1, bank2,

bank3, so on.


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yTo begin with let us suppose that an

individual A makes a deposit of

Rs.100 in bank1.

y

Bank1 is required to maintain a cashreserve requirement of 5%

(prevailing rate) which is decided by

the RBIs monetary policy, from thedeposits made by A.


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yBank1 is required to maintain a cash

reserve of Rs.5 (5% of Rs.100). The

bank has now lendable funds of

Rs.95 (Rs.100-5).

yLet the bank1 lend Rs. 95 to a

borrower; say B. The method of

lending is the same that is bank1opens an account in the name of the

borrower for the loan amount.


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y At the end of the process of deposits &

lending, the balance sheet of bank reads as

given below:-

LIABILITIES AMOUNT ASSETS AMOUNT

As deposits 100 Cash reserve 5

Loan to B 95

TOTAL 100 Total 100


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yNow suppose that money

borrowed from bank1 is paid to

individual C in settlement of his

past debts.

yThe individual C deposits the

money in his bank say, bank2. Now

bank2 carries out its bankingtransaction.


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y It keeps a cash reserve to the extent

of 5%, that is Rs.4.75 (5% of Rs.95)

and lend Rs.90.5 to a borrower D.

At the end of the process thebalance sheet of bank2 will look

like:-


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LIABILITIES AMOUNT ASSETS AMOUNT

Cs deposits 95 Cash

reserve

4.75

Loan to D 90.5

TOTAL 95 TOTAL 95


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yThe amount advanced to D will returnultimately to the banking system, as

described in case of B and the processof deposits and credit creation willcontinue until the reserve with thebanks reduced to zero.

yThe final picture that would emerge atthe end of the process of deposit &credit creation by the banking system ispresented in the consolidated balancesheet as under:-


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BANK LIABILITIES

DEPOSITS

ASSETS

CREDITS

RESERVE TOTAL

ASSETS

Bank1 100 95 5 100

Bank2 95 90.5 4.75 95Bank3 90.5 85.98 4.52 90.5

- - - - -

- - - - -

Bank n 00 00 00 00

TOTAL 2000 1900 100 2000


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y It can be seen from the combinedbalance sheet that a primary

deposits of Rs.100 in bank1 leads tothe creation of the total deposits ofRs.2000.

y It maintained a total cash reserve ofRs.100 which equals the primary

deposits. The total deposit createdby the commercial banks constitutesthe money supply by the banks.


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CONCLUSION

y To conclude, we can say that credit creationby banks is one of the important & only

sources to generate income.

y When the reserve requirement is increased

by the CENTRAL BANK it would directly

affect on the credit creation by bank becausethen the lendable funds with the bank

decreases and vice versa.

credit creation by banks

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